Abstract

Modern financial economics assumes that we behave with extreme rationality but we do not. Furthermore, our deviations from rationality are often systematic. Behavioral finance relaxes the traditional assumptions of financial economics by incorporating these observable, systematic, and very human departures from rationality into standard models of financial markets. This paper describes empirical tests of two predictions of behavioral finance: that investors tend to sell their winning stocks and to hold on to their losers and that, as a result of overconfidence, investors trade too much.

Statman and Shefrin (1985) predict that investors will sell their winning investments too soon and hold on to their losers too long. They dub this tendency the disposition effect. Using account data from a large discount broker, we document that individual investors are 50 percent more likely to sell a winning investment than a losing investment (relative to their opportunities to do so). The analysis also indicates that many investors engage in tax-motivated selling, especially in December. Alternative explanations have been proposed for why investors might realize their profitable investments while retaining their losing investments. Investors may rationally, or irrationally, believe that their current losers will in the future outperform their current winners. They may sell winners to rebalance their portfolios. Or they may refrain from selling losers due to the higher transactions costs of trading at lower prices. When the data are controlled for rebalancing and for share price, the disposition effect is still observed. And the winning investments that investors choose to sell continue in subsequent months to outperform the losers they keep. This investment behavior is difficult to justify rationally; it is pure folly in an investor?s taxable account.

It is difficult to reconcile the volume of trading observed in equity markets with the trading needs of rational investors. Rational investors make periodic contributions and withdrawals from their investment portfolios, rebalance their portfolios, and trade to minimize their taxes. Those possessed of superior information may trade speculatively, though rational speculative traders will generally not choose to trade with each other. It is unlikely that rational trading needs account for a turnover rate of 76 percent on the New York Stock Exchange in 1998. We believe there is a simple and powerful explanation for high levels of trading on financial markets: overconfidence.

Human beings are overconfident about their abilities, their knowledge, and their future prospects. Odean (1998b) shows that overconfident investors trade more than rational investors and that doing so lowers their expected utilities. Greater overconfidence leads to greater trading and to lower expected utility.

We present evidence that the average individual investor pays an extremely large performance penalty for trading. Those investors who trade most actively earn, on average, the lowest returns. And the stocks individual investors purchase do not outperform those they sell by enough to even cover the costs of trading. In fact, the stocks individual investors purchase, on average, subsequently underperform those they sell. This is the case even when trading is not apparently motivated by liquidity demands, tax-loss selling, portfolio rebalancing, or a move to lower-risk stocks.

Our common psychological heritage insures that we systematically share decision biases that can lead to suboptimal investment behavior. Overconfidence provides the will to act on these biases. It gives us the courage of our misguided convictions.